Tuesday, May 10, 2011

2-yr sovereign yields can be thought of as the market's best guess for the average short-term monetary policy rate over the next two years. Today's 0.6% yield on 2-yr Treasuries therefore means that the market is expecting the Fed funds rate to average 0.6% over the next two years: rising from today's 0.1% to 1.5% two years from now, with the first tightening not coming until until March of next year. 2-yr German yields, in contrast, stand at 1.7% today, which implies that the European Central Bank's target rate is expected to rise from today's 1.25% to a little over 2% two years from now.

The blue line in this next chart represents the difference between the yield on 2-yr Treasuries and 2-yr German bonds. The spread is currently negative, meaning that U.S. yields are trading substantially lower than German yields, and that in turn means that the market is expecting the ECB to be materially tighter than the Fed over the next two years. The fact that the red line (the value of the dollar against other major currencies) is fairly tightly correlated (0.81) to this spread strongly suggests that the Fed's accommodative monetary policy stance is largely responsible for the dollar's weakness; the Fed is expected to be much easier than other central banks, and that reduces the world's desire to own dollars (who wants to own a currency that is going to be in oversupply for the next two years?). By this logic, if the Fed were to tighten sooner and by more than the market currently expects, that would most likely result in a stronger dollar. Similarly, a decision by the Fed to postpone tightening would likely weaken the dollar.

LOL. Good point. If my aunt had a beard she'd be my uncle.A good reason why the global economy expanded in the 'past' 20 years was based on flawed, distorted, and corrupt fiscal, monetary, and Fed policy (sic). We would be left with $28+ trillion in 'unpayable' debt, mind numbing future legacy obligations, and a 'totally' worthless currency.